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Passive sense in exciting times

January 06, 2013

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There was a feeling of déjà vu when the FTSE 100 broke through the 6000 barrier this week. We’ve been there several times since the late ‘90s and, who knows, we may well pass it on the way up and down several more times yet.

Active fund managers like to make a big deal of the rollercoaster ride that share prices have been on since the turn of the century. The FTSE’s all-time peak of 6930 came in March 1999, with the next highest level being in October 2007 at 6721.

The stomach-churning lurches in between those dates, we’re told, are ‘proof’ that it’s now a ‘stock-picker’s market’ and that the age of ‘buy and hold’ is over.

As a recent editorial in Hedgeweek put it, “If a person was a passive investor over this period of time then ... as of now, depending upon the timing of their investment, their money has achieved very little at best or been reduced in value at worst.”

It seems a plausible argument on the face of it, but it doesn’t bear more than the most cursory scrutiny. And here’s why.

It’s about dividends as well as share prices Investors don’t simply buy shares in the hope they will rise in value. They also buy them - or at least they should do - for the income, or dividends, they provide. Throughout the so called ‘Lost Decade of Investing’, many companies continued to pay healthy dividends even as their share price was falling.

Diversification protects against volatility There are very few passive investors who put all their money into tracking the FTSE 100, or the S&P 500, which has experienced similar ups and downs. It’s certainly not a strategy we would recommend. An investor with a diverse portfolio, including shares in smaller companies, emerging markets, commodities including gold, government bonds and corporate bonds, should still do well even when most stock markets are going nowhere. A diversified portfolio held from 2000 to 2010 would typically have produced annualised returns of more than 8%.

Pound-cost averaging smooths out returns Clearly timing is a factor, but it’s only with the benefit of hindsight that we know when were the best - and the worst - times to invest in a particular asset class. Yes, in theory, an active fund manager is able to buy just before the market rises and sell just before it falls, but the evidence suggests they’re not as good at it as they’d like us to think they are. And of course, timing is much less of an issue for regular (as opposed to lump sum) investors. Those who, during the noughties, were investing small amounts each month benefited from buying in at lower prices as shares fell - the effect known as pound-cost averaging.

It’s long-term performance that matters Passive investing is a long-term strategy, and although the FTSE 100 has hovered above 6000 for a long time, it’s still a relatively short period in investing terms. Of course, some investors have a shorter time-scale than others, particularly those coming up to retirement. But again, if passive investors had been sufficiently diversified and sensibly weighted their portfolios towards bonds towards the end of their investing term, they should not have been unduly affected by the sharp fluctuations in share prices of the last 13 years.

So what can we conclude?

There are periods when market returns are lower than average and times when they are higher. FACT. Market returns so far this century have been relatively low. FACT.

You could have taken a risk on an active fund manager in 1999 and, depending on which one you chose, he may have been able to buck the trend. But the higher charges you would have paid for the privilege would have wiped out a substantial amount of any additional gains you may have made. And of course you could just as easily have picked a manager who couldn’t beat the market.

A far easier, cheaper and probably more rewarding strategy would have been to invest passively in a diverse range of assets.

So next time an adviser or an active fund manager cites the ‘Lost Decade’ as an argument against investing passively, beware that he’s probably trying to frighten you into paying for an expensive product you’d be better off without.

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